Wednesday, August 31, 2011

Bad Theorizing; Failing to Understand the Broken Window Fallacy

Gene Callahan has crash landed once again at his own site, in an attempt to prove that the Broken Window Fallacy doesn't apply under all circumstances.

He begins with this model construct:
Let us imagine an isolated valley. In that valley live an extremely wealthy loner, in a vast mansion with extensive grounds, and a large number of extremely poor subsitence[sic]farmers. They had been prosperous during the days when the loner had been constructing his estate, but now he is done, and there is no other work around.

Then a hurricane comes:
It causes extensive damage to the loner's estate. Suddenly, he has need to employ all of those other people in the valley again. The economy "picks up."
Callahan's conclusion:
Now, economic science has nothing to say about whether the valley is better off after the hurricane than it was before -- doing so would require interpersonal comparisons of utility. But it is clear that there is now more economic activity than there was before.

The point of this? Bastiat's "broken window fallacy" is not an a priori truth.

The problem with Callahan's theorizing is that he misses the point of the "Broken Window Fallacy". It is not that there is "now more economic activity than there was before." After destruction, there is always likely to be "more economic activity than there was before" in certain sectors. That a window is broken means that the window maker has more activity. But the point of BWF is that there is other activity that does not occur because of the broken window (or hurricane). What needs to be looked at, and what Callahan fails to look at, is what this loner would be doing with his money if he didn't have to pay it out to the local valley farmers to fix the destruction caused by the destruction. Would he be investing the money, which would likely increase the standard of living for himself and others? Would he now not be able to buy some caviar that he had planned on doing before the hurricane struck?

So when Callahan writes:
The point of this? Bastiat's "broken window fallacy" is not an a priori truth. It is more or less true, depending on the amount of crowding out that occurs in repairing the broken window. I have carefully contrived a scenario with 0% crowding out.
Callahan's model does nothing to make his argument. He has no idea what "crowding out" will occur. Nothing in his scenario says anything about 0% crowding out. We don't know, based on his model, what opportunities have been forgone by the rich loner. Destruction may bring more activity for some, in Callahan's model the valley farmers, but BWF is about the unseen activity, which Callahan has missed, as have all those before him who have not understood BWF.

Bottom line: If someone uses money to repair damage, that is money that is not used somewhere else.  A non-100% "crowding out" scenario sounds to me like some type of wacko Keynesian model where wage and other markets don't clear. Clearly, Callahan is going in this direction when he writes:
...100% crowding out...is implausible (at least in a recession), but not impossible.
If money is redirected because of damage, it sure as hell results in less money somewhere else, regardless of the unemployment situation. BWF holds. (Even  if the loner was hoarding the money as part of his cash balance, it means the loner now has a lower cash balance, which presumably would mean he considers himself less wealthy.)

31 comments:

  1. to be fair, i guess the idea is that in the situation where the the loner hoards the money, at least he now has to spend it to pay the poor farmers. which is some kind of redistribution of money, the result of which will be that the farmers will spend their newly acquired money on primary needs like food or clothes (thereby providing a salary for other poor farmers) that the loner would not have bought, at least not to this extent.

    ReplyDelete
  2. Keynesians always neglect at least two fundamental principles of economics:

    1) Human wants are unlimited.

    2) Economic activity is mostly made of transactions where each person gets some of his wants satisfied.

    Therefore, they constantly make straw-men based upon people being completely satisfied and executing no economic activity.

    They also mistake their command-and-control direction of other people as satisfying economic activity when in fact it only satisfies their desire to command-and-control other people.

    ReplyDelete
  3. What has happened? I can't believe Callahan is arguing something like this. Is he planning on becoming a keynesian, too?

    ReplyDelete
  4. I'm beginning to think that Keynesianism has spread not because it represents a positive system in itself, but rather because it enables everyone to find in it a justification for their own idiotic beliefs.

    When economics is almost entirely financed and monopolized by the state, then like Hayek noted about socialist leaders, "the worst get on top" by appealing to the lowest common denominator among the populace.

    ReplyDelete
  5. By this rationale the U.S. should drop atom bombs on its own cities. Think of all the prosperity that will come from rebuilding! And it'll solve unemployment by killing millions and getting the survivors working as builders. Genius!

    ReplyDelete
  6. He has missed an even more basic fact: the dis-utility of labor.

    ReplyDelete
  7. It's very clear that he never understood Bastiat in the first place.

    Instead of having a new suit and a window, the shopkeeper only has the window (with the same expenditure of money).

    Less stuff floating around in the economy means a less wealthy economy.

    I used to think that the problem with Keynesians was that they never read the broken window fallacy. Now I realize it's another example of leading a particularly stubborn horse to water.

    ReplyDelete
  8. What an idiot. Who donated a college degree to this guy?

    ReplyDelete
  9. @Wenzel

    One should always be very careful not to extrapolate from theoretical scenarios of one's own making.

    Both in ethics and in politics it can lead to quite erroneous results that would never obtain in the real world, because the details would be quite different.

    It is on the details that the results in the real world would depend.

    In Callahanistan, rich loners never do a darn thing after they make their money. They don't have a soul who depends on them, nor a friend, nor an aging relative. They don't eat or drink, or travel, or have leisure pursuits or even read.


    Not so on planet earth.

    How does the vast estate maintain itself without work? Who trims the lawns or blows the leaves? Who weeds and mulches and plants and trims the bushes? Who tends the flowers and the vegetables? Who paints the house, repairs the plumbing and the roof or washes the driveway? Who fixes the sprinklers and the pool, kills the varmints and termites, replaces screens and locks? What about the alarm system and the electric and the natural gas and the water and the trash collection and the landscaping?

    Vast estates need constant attention to just maintain themselves. What about his car? The mechanics, the car insurance?

    Who invests this man's money? Doesn't he derive income from Callahan? The bank gets a stream of income from him too. He has accountants and lawyers, an insurance company, probably a secretary or two, brokers, bankers. All of them and all the businesses which depend on the banks' loans, and all the people who depend on the these people or do business with him, get income from him.

    If the man spends on hurricane work, he is taking away income from everyone of these people who are invisible in Callahanistan.

    ReplyDelete
  10. Wenzel,

    Callahan's own assertion that economic activity will pick up for the poor farmers after the hurricane is not necessarily a truth either.

    What if the estate owner decides to leave the area for a place not prone to hurricanes? What if he has some life changing experience and decides he no
    longer wants a vast estate and becomes a hermit? What of the farmers then?

    His entire analysis is a complete mess.

    ReplyDelete
  11. One of the main fallacies in keynesian thinking is that economic activity equates to an increase in wealth. Money changing hands on its own does nothing to increase wealth. I could label my left hand "person A" and my right hand "person B" and exchange money back and forth all day between the two and there would be no increase in wealth. Wealth comes from production (in this case the unseen), which comes from investment or savings (which the rich man now has to divert into repairing a house which he already had).

    ReplyDelete
  12. can someone please specifically refute the point i made in the very first comment? thank you.

    ReplyDelete
  13. I think another important thing to take into account is the activity of the subsistence farmers prior to the hurricane. They may have been busy building the loner's house, but once that's done, they need to find some other means of being productive. If they have tied their prosperity to the needs of the wealthy loner, then they need to find other goods or services which the wealthy loner is interested in purchasing from them. Or some means of providing goods and services to those who have found other goods and services for which the wealthy loner is interested in paying.

    Learning carpentry to build a house might be wise choice of career; remaining a carpenter when there is no work for carpenters and waiting for a hurricane to come along and provide you more work probably isn't such a wise decision. Maybe in the meantime you could find some other skill which may not pay as well as carpentry during the construction boom, but which provides far more activity than carpentry when there's no construction needed.

    ReplyDelete
  14. He committed the fallacy while trying to point out how it doesn't apply. Priceless.

    ReplyDelete
  15. @Anonymous
    10.01
    There is nothing to refute. Of course, if hurricane damage entails poor farmers working, those poor farmer will get money for their "primary needs".


    IF.

    That if is the weak point. Hurricane damage might not entail poor farmers working at all. FEMA could come in and give it to their favorite contractors. Or the guy could do the work himself. Or give it to above-subsistence farmers in an adjacent area, who have better skills and actually cost less, though they charge more, because they are efficient and have good equipment and know what they're doing.

    You imply a value judgment by suggesting that a disaster that forces rich people with secondary and tertiary needs to hire poor people so they can satisfy primary needs is good.

    Why?

    The subsistence farmers might be poor for lots of reasons. Maybe they are hard-headed, despise skilled work, spend their time drinking, or many other things. How do you assume their primary needs trumps someone else's secondary needs, when the money in a FREE market?

    Who are you to decide?
    And if they can't take care of their primary needs as subsistence farmers, maybe they should move closer to where they can.

    There. Refuted.

    ReplyDelete
  16. I think you should run a tread where we can all come up with Keynesian Stupidities (KS) to boost the economy.

    Give Krugman some ideas.

    ReplyDelete
  17. Anon @10:01,

    1) "loner hoards the money... the poor farmers"

    You are confusing poverty with lack of money. The farmers are only "poor" in money terms. Callahan makes no mention in his construct of territorial monopoly (ie government) that has legal tender laws forcing people to accept only the estate owner's money as payment. Assuming that the loner is hoarding gold there is nothing preventing the farmers from using whatever money they prefer, perhaps silver, to facilitate trade among themselves.

    Furthermore, what is the result if the loner hoards gold? By the definition of the model, the owner is a loner and does not engage in trade with the farmers therefore prices (in terms of gold) can only be bid up to the extent of the gold supply outside the hands of the estate owner. If this "outside" gold supply is so small that divisibility becomes a problem then the farmers can switch to another money, perhaps silver. Now the "poor" farmers (in gold terms) are "wealthy" (in silver terms) whereas the "wealthy" (in gold terms)estate owner is "poor" (in silver terms).

    In conclusion we can see that (absent a monopolization of money) there is no problem in Callahan's model to begin with because the farmers are only "poor" in relation to the money that the estate owner is hoarding. Drawing from the construct we know that during the construction of the estate the farmers were dishoarding their gold reserves in exchange for services from the estate owner (who for some reason decided out of nowhere to become isolated). This means that the farmers valued the gold less highly than the goods received in return and are therefore wealthier (in real, or capital goods, terms)!

    2)"at least he now has to spend it"

    False. It does not follow that he must spend his money to repair his estate. Indeed if he really is a true loner, as defined by Callahan, then why would he want the assistance of the farmers to rebuild his estate?

    3) "which is some kind of redistribution of money"

    As I noted in (1) there is no mention of Callahan by a territorial monopoly and therefore there are no taxes, or theft, of funds that can be distributed. It is an isolated free-market economy and thus funds are not distributed, they are earned by exchanging for another good.

    4) "the result of which will be that the farmers will spend their newly acquired money"

    Who is to say that, after years of isolating himself from the rest of the community, the farmers will want to engage in trade with the farmer? Perhaps the farmers have already adopted a new money, say silver, now the estate owner is "poor" (in silver terms)!

    5) "primary needs like food or clothes"

    Lila dealt with this pretty well above.

    6) "thereby providing a salary for other poor farmers"

    Again confusing wealth (a stock of capital goods and services) with money. If these other farmers are so "poor" then how do they have additional food and clothes to not only address their immediate needs but enough in excess to sell to other farmers?

    ReplyDelete
  18. The "poor" gang up/vote for terrorists that use political violence (laws) to steal from the wealthy Loner via property tax so that none of them have to work for a living. What will happen to them after there is nothing left to steal?

    ReplyDelete
  19. Anon at 1:52am, in this article I tried to bend over backwards to be fair to Callahan on this issue. I still think he is wrong.

    ReplyDelete
  20. Bob,
    You mentioned that "Even if the loner was hoarding the money as part of his cash balance, it means the loner now has a lower cash balance, which presumably would mean he considers himself less wealthy." This is very true but no one gives a crap about those Ebeneezer Scrooges and their "feelings". Mises (or maybe it was Rothbard)made a great point about hoarding:

    Hoarding Money=removing money from circulation.

    Money (whatever currency is used) is not excepted from the laws of supply and demand. Reduce supply by removing it from circulation and it will increase the value of the money that remains in circulation (because it is more scarce) by a factor in proportion to how much is removed.
    This is the inverse of the very same mechanism that drives inflation. Increase the supply of money and it devalues the existing supply by making it less scarce.
    So, assuming the miser and the farmers use the same currency, the miser is making the farmers richer in what money the do have by restricting the money supply. If he is forced to lift up his mattress and flood the valley with his "new" money to rebuild his house, some people (the architect and building department, for example)will benefit because they will be first in line and they can use this "new" money to buy goods and services at today's prices. By the time the painter and carpet installer get paid for their work, however, the new money will have bid up prices on "primary needs like food or clothes" to the point where they can't afford it any more than they would have before.

    Anon @152, I hope this helps answer your questions as well.

    ReplyDelete
  21. "Now, this is a very artificial example, I grant you... it is set up to show a *possibility*, and not a likelihood. But at his blog Bob Murphy also agreed that my example showed exactly what I intended it to show."

    Let's see the possibility Gene is pointing us to.

    This possibility is a case where a valley's population consists of one lone rich individual and a group of poor individuals who can only work as construction workers. These two particular assumptions are very interesting: (A) there are individuals who can work very very specific type of work; they can not work anything else than construction. (B) there is one lone individual who somehow got rich, but Gene does not reveal to us how could that happen;
    So, we know that miraculously one guy got rich and others are poor and can do only X (building).

    Please note that these assumptions are very very narrow. They are so narrow that it leaves the impression that the guy who thought of the example tried very hard to think of a completely IMPOSSIBLE AND ABSURD situation in order to "disprove" the broken window fallacy, by pointing out that in this situation there is possibility that the conclusions from BWF are not valid.

    Since Bastiat lived in the reality, I do live in the reality and human beings as a whole live in the reality and not in some situations that can be possible only in the human mind of Gene, the BWF conclusions apply to the reality, too. When he wrote about the "unseen" he did not care about non-existent situations.


    --------------
    I believe that a fair statement that resolves the topic is this:

    A disastrous event that destoys resources can not make the human welfare better than it would have been in case the event did not happen. Not only that but it is
    certain that it will make it worse because the accumulated stock of goods will be diminished.
    ---------------

    Respectively these "boosted employment" and "Economic activity" theories do not refute in NO WAY the above statement. As many people have pointed out already - economic activity does not mean an increase in wealth; and the "no net crowding out effect" is incorrect because even if the rich guy hoarded his money before the event, it does not mean that he eventually wouldn't have spent it, after all it is money - media of exchange - it does not matter whether he spends it sooner and "creates" employment in the present or spends it later and "Creates" employment in the future.

    I believe that if you are an "employment guy fetishist" who cares only about the present (this means that your are a Keynesian by the way) than you could argue that it is better for the economy of the rich guy who hoards his money gets his house destroyed, which will create employment in the present. But this is MERELY an opinion regarding your preference. It does not mean anything above that.

    ReplyDelete
  22. This comment has been removed by the author.

    ReplyDelete
  23. Considering Callahan's training and background, I doubt this is lack of logic. There must be something more going on here.

    Maybe a move to the mainstream or to the halls of power or something like it...

    ReplyDelete
  24. Gene's argument that a particular action could be considered ethical if a large number of people benefit is simply absurd. According to this logic the cleansing of ethnic minorities would be ethical if the ethnic majority benefited. He has just justified genocide.

    My history may be wrong, but I believe that Jews were an ethnic minority at the time of Hitler and I am sure that had Hitler exterminated all the Jews, confiscated all their wealth, then distributed that wealth among the German people, most of them would have benefited. Is he saying that this is ethical? If actions that are wrong for individuals to do suddenly become right when some critical number of people is reached, we are all doomed.

    ReplyDelete
  25. What happened to Mr. Callahan, anyway? How did he go from being the author of 'Economics for Real People', and (if I recall correctly) something of an Rothbardian anarcho-capitalist, to ...whatever one should call him now? If he's written a 'Why I Converted' essay, I haven't seen it; I haven't been able to find much of anything else on what happened. Did he just, one day, flip out? Fall in with a different crowd, then start following them? What happened, if it is not too impolite to ask?

    ReplyDelete
  26. Bastiat's concept of the seen and the unseen is hard for the blind to grasp.

    ReplyDelete
  27. @ Anon 6:27

    Trust me, I conjured up a myriad of refutations that are quite similar to yours, but I instead let it be. Don't get me wrong, I wanted to reply, but I abstained due to the fact that I knew that I would get another one-line comment (maybe even two lines) that not only doesn't refute my statement, but also leaves so many holes that I have to then address other things that are immaterial to my essential argument. Why bother?

    @ Anon 8:29

    Who knows? I have heard a few interpretations of what happened, but most of them are merely hearsay. My personal opinion is that at some point in the past he realized that being an Austro-libertarian doesn't necessarily confer any research grants or highly-payed, tenured positions. As somebody who has some basic grasp of the fundamental axioms of economics, as well as history, I cannot say that I blame him (necessarily). It seems, however, that with current trends in economic thought and reality, that he will probably follow the same path of the likes of Irving Fisher- except, Callahan never conceived of anything new.

    ReplyDelete
  28. This comment has been removed by the author.

    ReplyDelete
  29. Too bad that Callahan is going to the dark side. I really liked Economics for Real People, and even gave it to a friend interested in Austrian Econ as a primer.

    I suspect as it has been said above that there is not the power, money, or esteem in being an austrian and it finally took its toll. Not everyone can be like Mises, Rothbard, Ron Paul, etc and stand alone against the establishment for decades without quitting...

    ReplyDelete
  30. Hey, forget about rich loners and unemployed farmers and theory.

    Here's Human Action in practice:

    A woman builds her own house:

    http://www.backwoodshome.com/articles/ainsworth32.html

    "Thoreau said, “Simplify, simplify!” I drive an $800 pickup, eat like a peasant, buy clothes at Goodwill, and never watch TV. Creature comforts are a hot shower, warm bed, and the wood stove a-cracklin’. Designer nails mean “ring-shank” building nails, not bright red talons studded with diamonds. Give me my morning coffee and I’m happy.

    With my vanity years behind me, I’ll do most anything for a laugh. I measure life in strong heartbeats, daily accomplishments, and peace of mind. Happiness is having my own approval.

    Knowing I’ll get all the sleep I need after I die, when my body isn’t moving, my eyes are. I love to read and keep up on the latest in science, medicine, and technology. Photography is my hobby. "

    ReplyDelete
  31. Voluntary CooperationSeptember 1, 2011 at 2:24 AM

    Opportunity cost. Google it and educate yourself Callahan.

    ReplyDelete